Sie sind auf Seite 1von 51

PRAISE FOR VALUE LEVERS:

E
Kenneth H. Marks, CM&AA, CFq
Kenneth is an entrepreneur
and subject matter expert in INCREASE THE VALUE OF YOUR

U
mergers, acquisitions and
financing of emerging-growth
BUSINESS FROM 3X TO 7X

L
and middle-market companies.
He is the lead author of It turns out that viewing your business through the lens of an acquirer can be a great way

A
to maximize your companys value, even if you are never planning to sell. Value Levers will
Middle Market M&A: help you understand how valuation experts deconstruct a business to assess its worth and
Handbook for Investment Banking and if you internalize the lessons in this short book, youll be well on your way to turbocharging

V
Business Consulting and the Handbook of your valuation multiple.
Financing Growth: Strategies, Capital
Structure and M&A Transactions, both Jesse Lipson, ShareFile Founder / GM of Cloud Services at Citrix
(former member and RTP Chapter President, EO)
published in the John Wiley & Sons finance
INCREASE THE VALUE
series. Kenneth is a Certified Merger &
OF YOUR BUSINESS FROM

3X 7X
Acquisition Advisor (CM&AA) and holds The journey of building realizable value in your business can bring you into contact
a Corporate Finance Qualification (CFq). with professionals throwing around all kinds of technical terms. These authors have TO
deep technical experience with value creation. But theyve done a great job here of
moving past the jargon and explaining in simple, clear terms what it takes to realize
John (Buddy) A. Howard, CFA, ASA the full potential of your business. Keep these checklists close at hand!
Value Levers: Increase the Value of your
Buddy has more than 30 Mary Adams, Founder, Smarter Companies and Member, Exit Planning Exchange
Business from 3x to 7x is for owners, managers
years of experience as a
valuation and financial and advisors of private, middle-market
analyst. He has achieved his Value Levers is the perfect read for those wanting to understand how to measure or companies. Those that are thinking about
Chartered Financial Analyst more importantly enhance the assets of a business. Short, to the point and easy to
read, Value Levers should be required for those wanting to acquire, sell or more selling their business or that choose to
(CFA) designation from efficiently operate a business. implement mergers, acquisitions or growth
the CFA Institute and his Accredited Senior
Appraiser designation (ASA) in Business Christopher W Gaertner, Global Head Corporate Finance, strategies in todays environment often face
Valuation from the American Society of Technology Investment Banking, Credit Suisse challenges when engaging with the capital
Appraisers. He has held various securities markets, particularly when bridging the
licenses, including a Series 7 (General
Kenneth and Buddy have written a compact yet powerful guide to increasing your firms valuation gap between market values and
Securities), Series 24 (General Securities
value. Following their time-tested value levers for increasing returns, decreasing risks, owner values. This short book applies
Principal) and Series 86/87 (Research Analyst). and becoming transaction-ready will result in higher shareholder value. Every business
owner should read and implement these important ideas. traditional corporate finance theory to the
real-world dynamics of private, middle-
Kenneth and Buddy are partners of Jim Buck, PE, Partner, Tillery Capital; former member of the Entrepreneurs Organization (EO)
market companies and outlines practical
High Rock Partners, Inc. located in Raleigh,
North Carolina. The firm is a boutique steps to shrink the value gap while increasing
strategy and M&A advisory firm focused the value of your business and becoming
on serving middle-market companies. transaction-ready.

The authors of Value Levers: Increase the Value


of your Business from 3x to 7x are experienced
advisors and deal-doers with real-world
insights into optimizing the value of a company.

www.HighRockPartners.com Wyndham Business Press Visit www.ValueLevers.net for additional


WRITTEN BY THE LEAD AUTHOR OF
MIDDLE MARKET M&A: HANDBOOK FOR INVESTMENT BANKING AND BUSINESS CONSULTING content and tools.
AUTHOR COPY - NOT FOR DISTRIBUTION

ADDITIONAL PRAISE FOR


VALUE LEVERS

Value Levers is an interesting and thought-provoking read with many excellent


ideas, even for an experienced guy like me whose been on one side or the other in
dozens of deals, from simple asset purchases to complicated multiple-entity mergers.
This is a what-to-do guide and has caused me to now review some of our current
companies from the lenses provided. Im convinced following these steps will
increase the multiples during an ownership transition.

Joe McKinney, President/CEO,


McVantage Group of Companies; YPO member

As a business owner and a thought leader in the private business marketplace,
experts like Kenneth Marks give you value growth ideas that can result in a
near-immediate impact. At a time when the marketplace for private companies
is challenged with the largest value gap I have ever seen, I highly recommend
this book to any business owner or investment or transactional advisory professional.

Michael R. Nall, CPA, CM&AA, CGMA,


Founder, Alliance of Merger & Acquisition Advisors (AM&AA)
and Co-Founder, MidMarket Alliance

Kenneth Marks is one of the leading M&A professionals in the Southeast, and he
and Buddy Howard have summarized in a clear and concise manner the key value
drivers involved with increasing a companys valuation. This book is an excellence
reference for the seasoned M&A professional and a great overview for the business
owner considering an exit with no experience selling a company.

David Kidd, Managing Partner, Adirondack Growth Capital

PLEASE DO NOT DISTRIBUTE - COPYRIGHT 2016


AUTHOR COPY - NOT FOR DISTRIBUTION

PLEASE DO NOT DISTRIBUTE - COPYRIGHT 2016


AUTHOR COPY - NOT FOR DISTRIBUTION

U E
A L
V INCREASE THE VALUE
OF YOUR BUSINESS FROM

3X 7X TO

PLEASE DO NOT DISTRIBUTE - COPYRIGHT 2016


AUTHOR COPY - NOT FOR DISTRIBUTION

Copyright 2016 Kenneth H. Marks and John A. Howard


All rights reserved.

ISBN: 0-9705569-0-X
ISBN-13: 978-0-9705569-0-5
Library of Congress Control Number: 2016903868

Wyndham Business Press


Raleigh, North Carolina

This short book is largely based on the academic work by the authors above
and reprinted with permission: Kenneth H. Marks, John A. Howard (2015), Optimizing
Private Middle-Market Companies for M&A and Growth, in Cary L. Cooper, Sydney
Finkelstein (ed.) Advances in Mergers and Acquisitions (Advances in Mergers and
Acquisitions, Volume 14) Emerald Group Publishing Limited, pp.67 82.

PLEASE DO NOT DISTRIBUTE - COPYRIGHT 2016


AUTHOR COPY - NOT FOR DISTRIBUTION

Our work is dedicated to building Gods kingdom.

PLEASE DO NOT DISTRIBUTE - COPYRIGHT 2016


AUTHOR COPY - NOT FOR DISTRIBUTION

PLEASE DO NOT DISTRIBUTE - COPYRIGHT 2016


AUTHOR COPY - NOT FOR DISTRIBUTION

CONTENTS

PREFACE . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2

INTRODUCTION . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3

INCREASING THE RETURN ON INVESTED CAPITAL . . . . . . . . . . . . 76

REDUCING THE RISK OF INVESTMENT . . . . . . . . . . . . . . . . . . . . . . . . . 15


13

EASING THE TRANSFER OF OWNERSHIP . . . . . . . . . . . . . . . . . . . . . . 27


21

FINAL THOUGHTS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 35

CHECKLIST OF KEY POINTS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 39

FORMULA DEFINITIONS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 41

ABOUT THE AUTHORS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 42

OTHER RESOURCES . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 43

REFERENCES . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 44

PLEASE DO NOT DISTRIBUTE - COPYRIGHT 2016


AUTHOR COPY - NOT FOR DISTRIBUTION

PREFACE
Before you embark on reading this short book, I would like to set
the context for thinking about the content we are sharing. My business
partner (and co-author) and I spend the vast majority of our time
working with owners and CEOs of middle-market companies. In 2015,
we wrote a chapter in an academic book called Advances in Mergers
& Acquisitions, Vol 14, about optimizing private middle-market
companies for mergers and acquisitions (M&A) and growth. The
concepts we laid out in that chapter, and in this short book, are based on
years of investment banking and corporate development work coupled
with our collective experience researching, writing and teaching about
how to successfully finance, grow, position, buy and sell companies.

We spend a lot of our time understanding owners ambitions and needs,


and then working through corporate strategy to meet those goals. A
common theme we see in our work is the need for owners to increase
the value of their businesses and position them for a future transaction.
Sometimes the transaction is a sale of a company, sometimes an acquisition
or sometimes a financing for either growth or recapitalization. Our
desire with this publication is to share our findings in a short and concise
text that discusses the key levers that impact value and that might allow
a company to increase the realizable multiple applied to cash flow by a
buyer or investor in a transaction. The typical valuation metric used in
these kinds of deals is a multiple of earnings before interest, taxes, de-
preciation and amortization (EBITDA); the ideas in this book have the
potential to move the EBITDA multiple from 3x to 7x.

Hopefully, this short book will spur your thinking and provide some
high-level guidance to get you started or to move you closer to reaching
your or your clients objectives. To further help, we are building-out
tools and content for your use at www.ValueLevers.net. As always, we
are open to discussion, feedback or questions.

Kenneth H. Marks, CM&AA, CFq


Managing Partner at High Rock Partners, Inc.
khmarks@HighRockPartners.com
(919) 256-8152
2
PLEASE DO NOT DISTRIBUTE - COPYRIGHT 2016
AUTHOR COPY - NOT FOR DISTRIBUTION

INTRODUCTION
For private, middlemarket companiesthose companies
with annual revenues from $5 million to $1 billionvalue
creation is principally based on long-term, expected future
cash flow. In practice, the activities that lead to value
creation are nearly the same when preparing for a financing,
a wave of growth or an M&A transaction.

3
PLEASE DO NOT DISTRIBUTE - COPYRIGHT 2016
AUTHOR COPY - NOT FOR DISTRIBUTION

Owners of private companies tend to manage the business to minimize


taxes and maximize the current cash benefit to the shareholders. While this
approach makes sense in the short term, it often over-weights decisions
and strategies for immediate impact at the expense of what outside investors
or lenders would consider long-term value creation. Many times, improving
the realizable value of a company means shifting its approach and stance
from one that is reactive to one that is proactive. Taking a proactive stance
means, among other things, a company will tackle tough issues and instill
disciplines like those in which an institutional investor would insist. A
useful question for management to ask in readying their company for
change is What would a private equity buyer do to improve my business?
The answer to that question will likely provide keen insights and areas of
focus. That is what we hope to provide in this short book.

Essential to increasing the value of a company is increasing the amount


and certainty of its cash flow while reducing the risk of achieving that cash
flow. Optimizing the business should result in both a shift in the market
value of the company towards the upper end of valuation benchmarks and
an increase in its alternatives (more buyers, cheaper capital, etc.) when
engaging with the capital markets. Our discussion here centers on those
value levers most critical to the optimization of private, middle-market
companies from the perspective of those in the capital markets, including
institutional investors, lenders and buyers.

As we begin this analysis, keep in mind that strategic decisions need to be


thought of and developed by aligning the companys long-term growth
strategy with the right leadership team and the appropriate entity and
organizational structure supported by scalable systems, and capitalized by
the proper funding sources. Management must also consider changes to a
company relative to its stage and lifecycle within its specific market.

Calculating the value of a stream of cash flow can be illustrated in


mathematic terms by this simplified formula1.

expected cash flow


VALUE =
cost of capital growth rate of the cash flow

There are variations of this formula that account for fast-growth businesses, and for those with
1 

4 negative short-term cash flow and positive long-term cash flow. Further explanation of this
formula is provided at the back of the book.

PLEASE DO NOT DISTRIBUTE - COPYRIGHT 2016


AUTHOR COPY - NOT FOR DISTRIBUTION

According to this equation, we can increase value by increasing the


absolute value of the cash flow, reducing the cost of capital or increasing
the rate of growth of the cash flow (or any combination of the three).
Reducing the cost of capital is, in part, directly related to the risk of
achieving that cash flow. To frame the discussion and apply some basic
corporate finance concepts, we will look at value creation and optimi-
zation of a private, middle-market company as an exercise with three
distinct types of value levers: (i) pursuit of strategies that increase the
return on invested capital, (ii) pursuit of strategies that reduce the risk of
investment in the company, and (iii) pursuit of tactics and strategies that
ease the transfer and reduce the companys specific risk of transitioning a
business to new owners (whether transferred in part or in whole).

Keep in mind that certain businesses dont generate positive cash flow
in the early phase of their lifecycle but do create significant inherent
value. From a buyer or investor perspective, these companies may have
captured (or are capturing) a significant customer base or developing a
technology that will eventually lead to relatively large and material cash
flows. The discussion and concepts in this short book still apply.

Lastly, strategic position is an important lever that is


discussed in both the first and second chapters.

Visit www.ValueLevers.net for additional


content and tools.

REDUCE
DEAL
REDUCE FRICTION
INCREASE RISK
ROIC

5
PLEASE DO NOT DISTRIBUTE - COPYRIGHT 2016
AUTHOR COPY - NOT FOR DISTRIBUTION

PLEASE DO NOT DISTRIBUTE - COPYRIGHT 2016


AUTHOR COPY - NOT FOR DISTRIBUTION

INCREASING
THE RETURN
ON INVESTED CAPITAL

7
PLEASE DO NOT DISTRIBUTE - COPYRIGHT 2016
AUTHOR COPY - NOT FOR DISTRIBUTION

INCREASING THE RETURN ON


INVESTED CAPITAL
One of the common ways to measure return on invested
capital (ROIC) is to divide (i) net operating profit less
adjusted taxes by (ii) total assets minus non-interest
bearing liabilities (Copeland, 1996)2.

operating profit adjusted taxes


ROIC =
total assets non-interest bearing debt

To increase the ROIC, a company can either increase its operating profits
and cash flow while maintaining the same level of invested capital, or it
can reduce the amount of invested capital while maintaining the same
operating profit and cash flow. Under ideal circumstances, management
will do both simultaneously.

Below we discuss five key levers that can work to manage, control and
increase the ROIC. The primary outcome of moving these levers should
be increased cash flow and improved capital efficiency; however, a
possible, secondary effect of moving these levers is an increase in the
rate of growth of that cash flow. Preparation for growth or for an M&A
transaction includes developing and prioritizing appropriate initiatives
to optimize the ROIC of the company given the risk profile and ambi-
tions of the shareholders. As a company optimizes its ROIC, it is likely
to also experience improved operating metrics, such as better-than-
industry-average gross and EBITDA margins, and faster growth as
compared to its peers, both of which contribute to greater value.

2
Further explanation of this formula is provided at the back of the book.
8
PLEASE DO NOT DISTRIBUTE - COPYRIGHT 2016
AUTHOR COPY - NOT FOR DISTRIBUTION

1 Strategic Position

The strategic position of a company is essentially its competitive stance


relative to its peers and industry or market segment. Ideally, the better a
companys strategic position, the greater its ability to win and maintain
business and add value for its customers. At a minimum, management
should (i) understand the market and the companys competitive
position, and (ii) evidence and validate the companys relative position.
Third-party validation is often helpful in addressing both of the these.
For example, being recognized in specialized industry or segment reports
that highlight a company can be useful, assuming the company is in a
strong position. Industry awards and recognition are another means to
validate strategic position. A company in a weak or average position may
need to implement initiatives to create a stronger position or reposition
to a sustainable posture.

In todays world, few companies can thrive in a vacuum, so creating


a network of alliances or partnerships can help to gain advantage in a
marketplace. Alliances or partnerships might provide cost or supply
advantages, unique capabilities, desired sales channels or access to tech-
nologies that competitors cant easily duplicate. These relationships can
improve the competitive position of a company and provide evidence of
the value of that company, particularly if the alliance or partnership is
with a recognizable industry player. Ideally, a companys strategic position
will logically fit and address the industry or sector trends and play into
them in a way that is advantageous going forward. Whether the companys
strategic position has recently emerged, has slowly evolved or is well
entrenched, being able to articulate and leverage that position is an
important part of the growth story and the foundation upon which to
build an operating strategy.

9
PLEASE DO NOT DISTRIBUTE - COPYRIGHT 2016
AUTHOR COPY - NOT FOR DISTRIBUTION

2 Customer Base

The competitive and strategic position of a business is linked to its


go-forward customer base. As a company transitions from one stage of
growth to another, the customer base evolves. A goal in optimizing the
value of the business at the time of a transaction is to establish a customer
base that appreciates the value the company provides and is willing to
pay for it. Does the company have a customer base it can build upon
and grow? Do these customers fit the profile of what can be thought of
as ideal customers?

Since buyers or investors are paying for future cash flow, they will pay
significant attention to the quality of revenues, earnings and cash flow.
The strength of a companys customer base which obviously is the
driver of revenues and, therefore, cash flow can greatly influence the
quality of earnings/cash flow and how well those earnings represent
future projections based on the strategy of the business. The process of
improving the quality of revenues and earnings may very well include
culling customers that are problematic, low margin, slow paying, or that
are otherwise consuming resources or products/services that arent core
to the future of the business and replacing these customers with those
that more closely fit the ideal profile. To improve the value of the business
is to more tightly align the customer base with the growth strategy, giving
it a higher quality of revenues and earnings.

10
PLEASE DO NOT DISTRIBUTE - COPYRIGHT 2016
AUTHOR COPY - NOT FOR DISTRIBUTION

3 Cost Structure & Scalability

As with the customer base, the operations of a company should be


configured in the context of its overall growth strategy. From a buyer or
investor perspective, these decisions could include outsourcing non-core
activities, automating processes, optimizing the mix of contract vs.
permanent employees and improving utilization of facilities. Any of
these changes can have an impact on the cost of goods and services,
research and development, sales, general and administrative expenses,
and they should be synchronized with the growth strategy and the stage
of the company.

To create operating leverage, management might explore how the


structure of a specific operating area or capability within the company
could allow the business to ramp-up its revenues and output dis-
proportionally to the required investment or expense. The greater the
disproportionality, the greater the scalability implied, particularly
where the contribution margin of incremental revenues grows as
the business grows. With a high-growth business, this scalability
would likely be seen as creating additional enterprise value. Some
software companies, for example, have transitioned away from the
traditional enterprise model and adopted a software-as-a-service
model, in which a significant number of new customers can be
added with relatively minimal new costs, creating a dramatic
impact to valuation. This is one of the reasons that companies
such as Facebook have such high valuations; customer acquisition is
often self-perpetuating, and the incremental cost is close to zero.

11
PLEASE DO NOT DISTRIBUTE - COPYRIGHT 2016
AUTHOR COPY - NOT FOR DISTRIBUTION

4 Working Capital

In accounting terms, working capital is equal to current assets minus


current liabilities. In middle-market M&A transactions (those beyond
the small, Main Street asset deals), the selling company is typically
expected to deliver a normalized level of working capital to support the
operations of the business post-closing. Calculating the working cap-
ital and figuring the basis for the analysis is somewhat of an art and
often changes depending on the norms of a specific industry. Historical
trends can be a sound baseline for establishing the target amount. The
argument that a buyer can operate the sellers company with less working
capital than the seller is hard to defend without evidence. In growth
financings, tightening the working capital cycle can provide a cheap and
quickly accessed source of funding. In both M&A and growth financing,
optimizing the working capital cycle and assuring efficient use of this
capital will increase the value of the business by decreasing or minimizing
the capital required to fund the operating cycle.

Modifying the working capital cycle within a company can touch


many aspects of the business. The approach and ability to make these
changes depends, in some part, on the relative strategic and competitive
strength of the company and the desirability of its products or services.
This is where we connect the dots from the discussions above. Typical
ways to tighten the working capital cycle include accelerating customer
payment or requiring pre-payment, extending supplier credit terms
to market norms, increasing inventory turns and reducing the overall
operating or process cycle times.

When a seller in an M&A transaction tightens the working capital cycle


a number of quarters prior to a sale, he or she demonstrates that the new
norm is sustainable. From a buyers perspective, this tightened working
capital cycle can reduce the risk associated with estimations when
negotiating the working capital target.

12
PLEASE DO NOT DISTRIBUTE - COPYRIGHT 2016
AUTHOR COPY - NOT FOR DISTRIBUTION

5 Human Capital

Engaging and developing the human resources of a company is the final


lever to highlight in our discussion about increasing the return on
invested capital. In fact, human capital is often the greatest investment
a business makes. To realize the highest value for this investment,
management should focus on three interrelated areas: continuous
improvement, incentives and culture. A companys ability to grow
and thrive is directly linked to its ability to attract, retain and reward
employees while engendering a sense of ownership and accomplishment
at all levels. When optimized, the integration of these three areas should
result in a culture of innovation, reduced costs, improved operating
efficiencies and the institutionalization of the knowledge and wisdom
of the business into the processes and systems of the organization
(Sanginario, 2014).

13
PLEASE DO NOT DISTRIBUTE - COPYRIGHT 2016
AUTHOR COPY - NOT FOR DISTRIBUTION

PLEASE DO NOT DISTRIBUTE - COPYRIGHT 2016


AUTHOR COPY - NOT FOR DISTRIBUTION

REDUCING
THE RISK
OF INVESTMENT

15
PLEASE DO NOT DISTRIBUTE - COPYRIGHT 2016
AUTHOR COPY - NOT FOR DISTRIBUTION

REDUCING THE RISK OF


INVESTMENT
Risk is defined as the variability of an expected return over
time (Damodaran, 1999). Once a buyer or investor has
bought into the companys growth story or established
an investment thesis and determined the potential
outcomes are within an acceptable range, the focus
of the analysis turns to risk mitigation and sharing, that
is, sharing the risks between the buyer and seller for a
period of time beyond closing the deal. Proactively
reducing or mitigating these risks can allow management
to increase the value of the company. A reduction in
the risks of the business should result in a reduced cost
of capital or lower expected variability from the target
return on investment and, thus, greater implied value in
the cash flow. This leads the owner to pursue strategies
that reduce the risk of investment in the company.

16
PLEASE DO NOT DISTRIBUTE - COPYRIGHT 2016
AUTHOR COPY - NOT FOR DISTRIBUTION

In practice, lowering perceived risks helps establish and build confidence


throughout the transaction process and decreases discounts or hedging by
the buyer or investor in pricing the business. The goal is to demonstrate
the possible value streams (which will eventually become cash flow)
generated by acquisition of or investment in the company and to
provide indicators that build confidence and increase the certainty of
achieving them.

In this discussion around risk, remember that private, middle-market


companies are not managed in the same way as public and larger
businesses. In private, middle-market companies, non-financial owner
and shareholder ambitions directly impact managements actions
and willingness to confront tough situations or make changes
that might otherwise make logical or strategic sense. Oftentimes,
difficult situations are not addressed until a change of ownership or a
crisis spurs improvement. In fact, the need to make tough decisions often
drives the change of ownership. The proactive acknowledgement of this
dynamic in itself can set the stage for releasing unrealized value within a
company, if not by making tough decisions, then by understanding what
the difficult decisions are and presenting the investment opportunity
as part of the solution. To a buyer or investor, inheriting hard
decisions and change management activities is risky and will likely
reduce the realizable value of the company. It is good practice, therefore,
to reduce a companys risk prior to a transaction by implementing
changes that address its critical challenges or issues.

The following discussion highlights some of the key areas of risk that
tend to surface in mergers, acquisitions and financings of private, middle
-market companies and outlines initiatives or actions that can be taken
to reduce those risks and increase the value of the enterprise.

17
PLEASE DO NOT DISTRIBUTE - COPYRIGHT 2016
AUTHOR COPY - NOT FOR DISTRIBUTION

1 Awareness and Planning

Few companies have fully optimized operations. As companies move


through their lifecycle, their risks and opportunities change, so the task
of managing risk is always in a state of flux. The first step in reducing
the risk of buying or investing in a company is to understand the risks
inherent in the type of business and the market in which it operates.
The second step is to understand the distinct risks specific to the
individual company. A combined understanding provides the basis for
assessing the overall risk profile and for plotting a path forward. During the
transaction process, the price and deal terms can hinge on managements
ability to clearly articulate what is being purchased or invested in and to
demonstrate a house truly in order. As mentioned above, management
that is aware of and acting to mitigate the risks of the business can
provide some comfort to outsiders who may have concern about
undisclosed or latent issues.

18
PLEASE DO NOT DISTRIBUTE - COPYRIGHT 2016
AUTHOR COPY - NOT FOR DISTRIBUTION

2 Growth Plans and Relative Position

Understanding and optimizing a companys strategic position can provide


the focus for important operating decisions. Improved positioning relative
to competition should increase long-term cash flow and reduce risk as it
relates to the companys relevance in its market. A breakout strategy is part
of the answer to the question of a companys current and future relevance.
At the minimum, a company should understand its growth scenario as
a standalone entity. To create a breakout strategy, a company needs to
understand its potential growth in the context of an acquisition or with
a significant infusion of capital. While the standalone scenario should
show sustainable growth based on the companys current capitalization
and earnings, a well-thought-out and validated breakout strategy can be
used as a negotiating lever for extracting additional value for a company
beyond what its current cash flow might justify. For example, a company
planning significant geographic expansion as its break-out strategy a
strategy that requires capital or resources to fully implement will want to
have actually expanded on its own, in at least a small way, to demonstrate
the scalability of the business. Further successful expansion could be the
basis for earn-out or milestone payments in the context of a sale of the
company.

19
PLEASE DO NOT DISTRIBUTE - COPYRIGHT 2016
AUTHOR COPY - NOT FOR DISTRIBUTION

3 Leadership Team

In evaluating and reducing the risk related to the leadership and


management of a company, one must look first at the organizations
dependence on the CEO, owner or entrepreneur and then at the
organizations bench strength. A company with a hands-on CEO who
makes all the decisions supported by functional managers is usually riskier
than a company led by a CEO who operates among a team of leaders
with individual decision-making authority and that is accountable to near
real-time performance metrics. From a macro perspective, a qualitative
assessment can be made by answering a few core questions:

Is the current leadership team organizationally healthy,


functioning and capable of growing the business to the
next level?

Have key relationships with suppliers and customers been


developed with multiple members of the leadership team?

Has the team developed a positive culture and organization


that learns and improves?

Have any of the key members of this team experienced or


led a company through this type of growth and operated
at the next level?

Are members of this team functionally learning on the job


or do any have domain and industry experience?

How successful has the team been in attracting, developing


and retaining others?

20
PLEASE DO NOT DISTRIBUTE - COPYRIGHT 2016
AUTHOR COPY - NOT FOR DISTRIBUTION

Has this team operated successfully together through a difficult


time or situation?

What has been the recent performance of the company under


the leadership of this team?

Is there an incentive for the team to perform and stay with the
company beyond a transaction?

Developing a leadership team that enables a positive response to these


questions and that can operate the company without need of any specific
individual generally reduces the risk of investment in that company.

This kind of leadership and management assessment will resonate with


most institutional investors, lenders and buyers. Nonetheless, many
private owners will make the argument that it is riskier for them to
hand off responsibility than to directly supervise or perform sensitive
functions, such as cash management, key customer relations and large
project management (Blees, 2014). This divergence of perception and
the practical implications that result can contribute to a valuation gap.

21
PLEASE DO NOT DISTRIBUTE - COPYRIGHT 2016
AUTHOR COPY - NOT FOR DISTRIBUTION

4 Predictability of Revenues
and Earnings
Historical financial performance is no guarantee of the future cash flow
of a company, but it does provide evidence about the companys level of
operating performance and managements ability to lead. Generally,
predictable revenues and earnings are considered to have greater value
and less risk than cyclical, seasonal or sporadic performance. The business
model of a company often dictates the risk associated with predictability.
For example, recurring or repeat, multi-year, contractual relationships
that are likely to continue over the long-term and that can be forecasted
are most desirable.

A bottoms-up revenue and expense forecast built on historical operating


performance and metrics tends to inspire confidence and allows a buyer or
investor to understand the value drivers of the business and the associated
risks. Future revenues and earnings evidenced by contracts and existing
relationships are often less risky than revenues and earnings based on
individual new sales from a broad market or new customers. An example
of a business between these two extremes is one with a history of sales
operations that documents how certain business or selling activities
directly correlate to certain customer responses and, in turn, lead to
certain types or amounts of new orders. While this provides a proven
and documented process for obtaining new business, revenue is generated
order by order. To reduce this type of risk, this business might move to
longer-term, well-defined contracts that provide backlog and visibility.

Of the various lenses for evaluating elements of the operating costs and
structure, one is based on the variability of costs and its impact to the
break-even level, especially for businesses that are seasonal or have episodic
revenues. A company that can manage through revenue fluctuations and
generate predictable earnings and cash flow is less risky than one with
higher fixed costs and less control of its performance.

22
PLEASE DO NOT DISTRIBUTE - COPYRIGHT 2016
AUTHOR COPY - NOT FOR DISTRIBUTION

5 Concentrations

Customer concentration, the phenomenon of a single customer contributing


a significant volume of revenues and/or consuming a large amount of the
companys capacity, is generally considered to be a risk to a companys cash
flow stability and, ultimately, longevity. The level at which concentration
becomes an issue can change based on industry and circumstances, though
twenty percent or more of annual revenues by one customer is likely to
trigger a closer look. A similar risk exists with supplier concentration,
especially where few alternatives exist for a critical resource. Having a
long-term contract with strong protective and termination clauses with
a significant customer can mitigate the risk of concentration. An even
better solution to customer concentration is to obtain more customers
and balance the mix of business. Supplier concentration can be mitigated
by securing long-term contracts that provide for committed resources or
products, finding a second source of supply or obtaining a co-right of
some type (e.g. co-right of production, ownership or sourcing).

Similar to the earlier mention in this book, this perspective of risk will
resonate with most institutional investors, lenders and buyers. However,
many business owners will argue that concentration within a few established
customers and suppliers where deeply entrenched relationships are
formed is less risky than diversification, and may enable them to optimize
their business performance (Blees, 2014). Again, this divergence of
perception, and the practical implications that result, is another factor
that contributes to a valuation gap.

23
PLEASE DO NOT DISTRIBUTE - COPYRIGHT 2016
AUTHOR COPY - NOT FOR DISTRIBUTION

6 Compliance

Unresolved compliance issues involving taxation, payroll and benefits,


labor laws and environmental regulations can indirectly impact the risk
and value of a company by increasing doubt or decreasing confidence in
managements ability or integrity. Direct impact to the value of a
transaction is usually carved out or indemnified separately. Compliance
issues often lead to valuation issues when they impact operating costs
and earnings. By proactively identifying compliance issues and then
developing corrective action plans that contain and resolve the issues,
you can begin the process of managing risk. In some cases, the company
will be better off if it resolves compliance issues before engaging in the
transaction process.

24
PLEASE DO NOT DISTRIBUTE - COPYRIGHT 2016
AUTHOR COPY - NOT FOR DISTRIBUTION

7 Keeping Current

Some businesses require heavy, ongoing investment to remain relevant


and growing. The need to make critical improvements in a business can
create uncertainty and risk for a buyer or investor and, in some cases,
can be a catalyst for a transaction. Companies that require significant
investment to stay current or to update in terms of technology,
facilities or equipment are often penalized in a transaction in two ways:
(i) the required change is seen as creating additional risk, and (ii) the cash
required to make the improvement to the company (beyond a normal
level of reinvestment) impacts the value attributed to the seller. This
situation is often found in companies that are undercapitalized, have
failed to earn a return great enough to reinvest or stay current, or in
which the owners have stripped the company of its capital and failed
to reinvest. Understanding the cause of the failure to remain current in
operations or products may allow management to develop a strategy for
addressing it; the eventual solution will differ depending upon the cause.

The companys ability to innovate is directly related to the concepts above


in assessing the risk of the enterprise. Is the company built on a single
product, technology or service? Or does it have a track record of success-
fully responding to market changes and opportunities that provide for
longevity, sustainability and continued relevance? The risk imputed for
innovation, or the lack thereof, will depend on the specifics of the company,
the market in which it operates and the needs of the buyer or investor.

25
PLEASE DO NOT DISTRIBUTE - COPYRIGHT 2016
AUTHOR COPY - NOT FOR DISTRIBUTION

PLEASE DO NOT DISTRIBUTE - COPYRIGHT 2016


AUTHOR COPY - NOT FOR DISTRIBUTION

EASING THE
TRANSFER
OF OWNERSHIP

27
PLEASE DO NOT DISTRIBUTE - COPYRIGHT 2016
AUTHOR COPY - NOT FOR DISTRIBUTION

EASING THE TRANSFER OF


OWNERSHIP
Optimizing the value and preparing for M&A transactions
and growth, which often include external financings, may
include addressing administrative and entity-related
issues that cause friction in the deal process and effectively
increase the risk of closing a transaction. The final concept
to address in our analysis is, therefore, greasing the skids
for a transaction and enabling management to increase
the ease of, and reduce the risk of, a transfer of a companys
ownership (in whole or in part). The following discussion
outlines the typical sources of friction in a transaction and
the techniques to improve the likelihood of accomplishing
the desired deal.

28
PLEASE DO NOT DISTRIBUTE - COPYRIGHT 2016
AUTHOR COPY - NOT FOR DISTRIBUTION

1 Financial Information

The standard for financial reporting and information used for valuation
is usually accrual accounting that complies with the generally accepted
accounting principles (GAAP) or the international financial reporting
standards (IFRS), depending on the country and agreed-upon basis for
the transaction. Financial statements prepared for tax and management
reporting purposes often fail to fully meet these standards, particularly in
the lower middle-market. A key way to prepare in advance for engaging
with the capital markets is to compile financial information, both historical
and prospective, that allows the parties to directly compare data and that
complies with GAAP or IFRS. Typical financial reporting problem areas
include: revenue recognition, year-end payroll and benefit accruals, asset
expensing vs. depreciation and normalization adjustments accounting for
specific owner-related benefits.

The objective of preparing financial information is to generate numbers


that allow direct comparison of revenue, gross margin, expenses, capital
expenditures (CAPEX) and EBITDA amounts and percentages within
the conventions of the specific companys industry. For a business with
critical mass or size, having audited or reviewed financial statements from
a credible and recognized accounting firm is important and, in some cases,
required. Even with reviewed or audited statements in hand, many parties
involved in M&A and financing transactions require an additional, external
assessment of the timing and value of cash flow of the business, which is
often referred to as a quality-of-earnings assessment.

29
PLEASE DO NOT DISTRIBUTE - COPYRIGHT 2016
AUTHOR COPY - NOT FOR DISTRIBUTION

Since value creation is based on future cash flow, it is important to


note that capturing, evaluating and optimizing the true economics of a
business includes understanding the required future investment in
CAPEX. Though this investment is often excluded from traditional
EBITDA metrics, it can have a significant impact that needs to be
understood to drive value growth. In addition to traditional financial
reporting, key performance measures, leading indicators and operating
data and metrics provide valuable insight into business operations and
allow management (and new owners) to react and adapt to changes
(Blees, 2014).

Having well-organized and accurate financial information allows the


parties to move deliberately and quickly through the analysis, decision
and negotiating phases of the deal and supports the momentum and
energy that builds as a transaction process advances.

30
PLEASE DO NOT DISTRIBUTE - COPYRIGHT 2016
AUTHOR COPY - NOT FOR DISTRIBUTION

2 Contracts

One determinant of the ease of transfer of a business is the ease of


assignment of its contracts from one owner to another. For businesses
with long-term customer contracts, agreements that are assignable and that
dont require a change of control consent by the customer allow flexibility
in determining the deal structure and reduce the risk of disrupting
customer relationships during the transition. This assignability challenge is
sometimes alleviated when there is a stock transaction, since the company
continues to exist post-closing. The same concept applies to various
other contracts that a company might have, including employee agreements,
supplier contracts, facilities leases, licensing agreements and debt instruments.
Based on the industry, size and stage of growth of the company,
management should consider the type of transactions that might benefit
its shareholders and shape its agreements accordingly.

31
PLEASE DO NOT DISTRIBUTE - COPYRIGHT 2016
AUTHOR COPY - NOT FOR DISTRIBUTION

3 Title to Assets

At some point in the process of completing an M&A transaction or


obtaining growth financing, the topic of defining and listing the assets of
a business will arise. This requires identifying both tangible assets (e.g.,
property, plant and equipment) and intangible assets (e.g., software, trade-
marks, patents, trade secrets and customer lists). Understanding what a
company owns and how much those assets are worth are factors in determining
the structure of a transaction and how purchase price is allocated (which
impacts taxes for both the buyer and seller). A step in preparing for a
transaction is to develop a comprehensive list of a companys assets and
establish and provide evidence of clear title. This may involve having
liens removed from public records. For intellectual property (IP), it may
require filings, registrations, releases or assignments depending on the
circumstances in which the IP was created. As with other areas of preparation,
working through the details of this step can take time. Waiting until the
time of a transaction to act can slow the process and increase costs of
a deal.

32
PLEASE DO NOT DISTRIBUTE - COPYRIGHT 2016
AUTHOR COPY - NOT FOR DISTRIBUTION

4 Corporate Structure and Attributes

Two common topics that arise when considering the legal entity and
structure of a transaction and the interaction with selling shareholders (or
members) are: (i) tax treatment of the selling entity and (ii) approvals by
the seller required to affect a transaction.

i. Optimizing after-tax proceeds from M&A transactions usually


requires long-term planning regarding the sellers type of corporate
entity and its tax status. Determining if, when, why and with
whom a company is likely to engage in the capital markets can
provide some guidance as to whether C-corp or S-corp (or
partnership if an LLC) status makes sense for optimizing the value
to its owners over time. Changing status on short notice is usually
punitive and might create practical barriers or negate the economic
value as the motivation for a deal, especially for transactions with
companies that have marginal performance.

ii. For entities with multiple owners with divergent levels of interest,
having clear authority to execute a transaction can be valuable in
preventing delays. A typical approach to control is for the majority
shareholder(s) to create a formal shareholder agreement (or operating
agreement for LLCs) that provides for drag-along rights of
minority owners. Another approach is to plan ahead and buyout
the minority, disgruntled or estranged shareholders well before a
transaction is imminent.

33
PLEASE DO NOT DISTRIBUTE - COPYRIGHT 2016
AUTHOR COPY - NOT FOR DISTRIBUTION

5 Dont Lose Focus on the


Core Business
A word of caution: it is important for management to remain focused on
company performance while engaging in a transaction or implementing
a growth strategy. The time, financial and emotional investment can
be overwhelming during the preparation and negotiation process, and,
because of the perceived urgency and critical nature of the demands,
normal management responsibilities often suffer, resulting in slower business
development and a lack of cost controls, just to name a few. What can
make this issue particularly troublesome in an M&A transaction (or a
growth strategy that involves outside funding) is the negative impact to
valuation, terms and conditions of a deal if performance begins to slip.
Prior to closing, interim financial statements will often be reviewed to
measure company results against projections or expectations. Though
some slippage is bound to occur due to the dilution of management
attention, poor business performance can affect the terms the buyer
or funding source originally agreed to. The risk is especially high in
situations with a protracted negotiating period.

34
PLEASE DO NOT DISTRIBUTE - COPYRIGHT 2016
AUTHOR COPY - NOT FOR DISTRIBUTION

FINAL THOUGHTS
In the discussion above, we defined the main levers that
management of a private, middle-market company can
use to increase the return on invested capital, reduce
the risk of investment and ease the transfer to new
owners for successful M&A transactions and growth
initiatives. Two additional influences will likely impact
the outcome:

35
PLEASE DO NOT DISTRIBUTE - COPYRIGHT 2016
AUTHOR COPY - NOT FOR DISTRIBUTION

MARKET TIMING
The level of industry transaction activity can affect value. In a hot and
active deal market, management may find it easier to attract capital,
investment and buyers at values and terms favorable to the company.
Certain industries and sectors experience waves of activity and
interest. On the front-end of these cycles, valuations and deal terms
will likely favor the seller and can provide an opportunity for owners
and management to act to monetize value closer to owner
expectations even if the company isnt ready.

COMPETITIVE PROCESS

The degree of process competition or engagement with
multiple bidders is important. The presence of multiple,
interested buyers or investors has significant potential positive
impact in optimizing the value for a seller or company
raising capital and increases the likelihood of closing a transaction.

Conversely, the buyer or investor who finds proprietary or


unique targets and acts quickly can seize valuable opportunities.
A well-managed transaction process with the right teammates
and advisors acting in accord should prove to be an investment
with a return and increase the likelihood of a successful out-
come. For many business owners, selling a business or obtaining
growth financing is like being on fourth and goal in the final
quarter of a football game there is no more critical time to
execute and to execute well.

36
PLEASE DO NOT DISTRIBUTE - COPYRIGHT 2016
AUTHOR COPY - NOT FOR DISTRIBUTION

As you think about what we have presented, preparing for and optimizing
a business in anticipation of M&A and growth takes time and planning.
In the public markets, shareholder value is paramount and is legislated as
the deciding factor for doing deals. In private, middle-market companies,
price goes along with the ambitions and motivations of its owners. The
transaction process can be a significant distraction to a company; sufficient
preparation that enables management to act quickly and deliberately will
have tangible value that should not be underestimated.

Achieving shareholder objectives and the desired deal value requires a


careful analysis and positioning in a way that can be done discreetly, with
confidence and on the shareholders terms. Plan ahead.

REDUCE
DEAL
REDUCE FRICTION
INCREASE RISK
ROIC

Visit www.ValueLevers.net for additional content and tools.

37
PLEASE DO NOT DISTRIBUTE - COPYRIGHT 2016
AUTHOR COPY - NOT FOR DISTRIBUTION

38
PLEASE DO NOT DISTRIBUTE - COPYRIGHT 2016
AUTHOR COPY - NOT FOR DISTRIBUTION

CHECKLIST OF KEYPOINTS

Increasing ROIC
1 Strategic position
2 Customer base
3 Cost structure & scalability
4 Working capital
5 Human capital

Reducing Risk
1 Awareness & planning
2 Growth plans & relative position
3 Leadership team
4 Predictability of revenues & earnings
5 Concentrations
6 Compliance
7 Keeping current

Easing the Transfer


1 Financial information
2 Contracts
3 Title to assets
4 Corporate structure & attributes
5 The core business
6 Market timing
7 Competitive process

Visit www.ValueLevers.net for additional content and tools.


39
PLEASE DO NOT DISTRIBUTE - COPYRIGHT 2016
AUTHOR COPY - NOT FOR DISTRIBUTION

40
PLEASE DO NOT DISTRIBUTE - COPYRIGHT 2016
AUTHOR COPY - NOT FOR DISTRIBUTION

FORMULA DEFINITIONS

expected cash flow


VALUE =
cost of capital growth rate of the cash flow

TERM DEFINITION

value Enterprise value of the company is equal to the market value of


the companys debt and equity
____________________________________________________________________
expected cash flow Future cash flow (normalized, after tax and after capital
expenditures but before interest expense) that is expected to be
generated by the business to service debt and then be available to
shareholders
____________________________________________________________________
cost of capital Weighted average expected return for debt and equity based on
the risk and capital structure of the business
____________________________________________________________________
Growth rate The annual rate of growth of the expected cash flow

operating profit adjusted taxes


ROIC =
total assets non-interest bearing debt

TERM DEFINITION

operating profit Normalized earnings before other income, other expenses,


interest and taxes
________________________________________________________________
adjusted taxes Cash payments for corporate income taxes
________________________________________________________________
total assets Total balance sheet assets using GAAP
________________________________________________________________
Non-interest bearing Liabilities that are not subject to accrued or actual interest
debt (those considered funded debt). Typically this includes
accounts payables and accruals

Visit www.ValueLevers.net for additional content and tools.


41
PLEASE DO NOT DISTRIBUTE - COPYRIGHT 2016
AUTHOR COPY - NOT FOR DISTRIBUTION

ABOUT THE AUTHORS


Kenneth H. Marks, CM&AA, CFq
Kenneth is the Founder and Managing Partner of High Rock Partners, a
boutique firm of strategic and M&A advisors. He is an entrepreneur and
subject matter expert in mergers, acquisitions and financing of emerging
growth and middle-market companies. He combines first-hand experiences
in financing, building and selling multiple businesses for himself with more
than twenty years of developing growth strategies and doing deals. He helps
CEOs make key strategic decisions, navigate and execute transitions of
ownership, accelerate growth to the next level or reposition the company.
His firm uses a unique and proven blend of experiences and tools in strategy,
mergers and acquisitions, financing and deals coupled with leadership and
creative solutions to achieve his clients desired outcomes.

Kenneth is the lead author of Middle Market M&A: Handbook for


Investment Banking and Business Consulting and the Handbook of Financing
Growth: Strategies, Capital Structure and M&A Transactions, both published
by John Wiley & Sons in their Finance Series. He has an electrical
engineering background and obtained an MBA from Kenan-Flagler
Business School at the University of North Carolina Chapel Hill. Kenneth
is a Certified Merger & Acquisition Advisor (CM&AA) and holds a
Corporate Finance Qualification (CFq).

John Buddy A. Howard, CFA, ASA


Buddy has more than 30 years of experience as a valuation and financial
analyst. He has completed more than 200 valuations in a wide variety of
industries and has served as an expert witness in the area of business valuation
approximately 30 times. Mr. Howard has been ranked in the top 50 M&A
advisors based on transaction volume in the banking sector according to
U.S. Banker.

He has achieved his Chartered Financial Analyst (CFA) designation from


the CFA Institute and his Accredited Senior Appraiser designation (ASA)
from the American Society of Appraisers. He has held a Series 7 (General
Securities), Series 24 (General Securities Principal), and Series 86/87
(Research Analyst) licenses.

42
PLEASE DO NOT DISTRIBUTE - COPYRIGHT 2016
AUTHOR COPY - NOT FOR DISTRIBUTION

OTHER RESOURCES

Kenneth H. Marks is the lead author


of Middle Market M & A: Handbook
for Investment Banking and Business
Consulting, 1st Edition,
ISBN-10: 0470908297

Kenneth H Marks is the lead author


of The Handbook of Financing Growth:
Strategies, Capital Structure, and M&A
Transactions, 2nd Edition,
ISBN-10: 0470390158

Visit www.ValueLevers.net for additional content and tools.


43
PLEASE DO NOT DISTRIBUTE - COPYRIGHT 2016
AUTHOR COPY - NOT FOR DISTRIBUTION

REFERENCES
Blees, C., Managing Partners, BiggsKofford Capital, Interview, December 2014

Copeland, T., Koller, T., Murrin, J. (1996). Valuation: Measuring and Managing the
Value of Companies, 2nd Edition. John Wiley & Sons, Inc. Hoboken, New Jersey.

Damodaran, A. (1999). Applied Corporate Finance. John Wiley & Sons, Inc.,
Hoboken, New Jersey.

Marks, K., Slee, R., Blees, C., & Nall, M. (2012). Middle Market M&A:
Handbook for Investment Banking and Business Consulting. John Wiley & Sons, Inc.,
Hoboken, New Jersey.

Sanginario, K., Founder, Corporate Value Metrics, Interview, December 2014

Visit www.ValueLevers.net for additional content and tools.

44
PLEASE DO NOT DISTRIBUTE - COPYRIGHT 2016